Short-term bond yields set to edge up with liquidity squeeze

Tue Jul 22, 2014 4:19am EDT

* ECB tender will struggle to offset LTRO repayments

* Money market pressure tipped to push up short-dated yields

* Long-dated bond yields edge up in light trading

By John Geddie

LONDON, July 22 (Reuters) - Short-term government bond yields and money market rates are poised to edge up on expectations of a drop in spare cash in the euro zone banking system, market analysts said on Tuesday.

Economists polled by Reuters predicted a small uptick in demand for the European Central Bank's one-week main refinancing operation (MRO) on Tuesday, but not enough to prevent a squeeze in liquidity with a bumper 21 billion euros of emergency loans (LTROs) set to be paid back on Wednesday.

Market strategists say a predicted fall in excess liquidity to one-month lows will push up overnight interbank lending rates , thwarting the ECB's efforts to keep a cap on countries' short-term borrowing costs.

"I think the demand on the next MRO will be slightly higher than the previous one, but we could still have quite a strong fall in excess liquidity," said Cyril Regnat, fixed income strategist at Natixis.

"Short-dated government bonds could come under pressure if we have a stable MRO."

Two-year yields in Germany - the benchmark for euro zone borrowing - edged up 1 basis point to 0.04 percent on Tuesday, and are tipped to edge higher in the coming days as liquidity drops.

Commerzbank strategist Rainer Guntermann said the liquidity squeeze that will come from a bumper LTRO repayment this week is a direct result of the ECB's decision last month to charge banks to keep their money in overnight deposits.

"You can't force banks to lend," he said, pointing out that it will take time for policymakers to achieve their goal of forcing money out of the financial system into the real economy.

The ECB tried to offset the pressure on excess liquidity last month by terminating its weekly deposit tender to neutralise the effect of the bond purchases it made at the height of the debt crisis, but the effects of this liquidity injection have already eased.

Excess liquidity closed at 128.8 billion euros on Monday, dropping from nearly 170 billion euros at the end of last month, and is expected to drop significantly after Wednesday's LTRO repayments.

Elsewhere, longer-dated government bonds all edged up slightly on Tuesday amid light summer trading volumes.

Traders said many investors were sidelined due to ongoing geopolitical tensions in the Middle East and Ukraine, or were waiting for scheduled supply in the form of a 10-year bond auction from Belgium and a new 30-year issue from the European Financial Stability Facility.

German 10-year bond yields were 1 bps higher at 1.16 percent, as were most other euro zone government bonds.

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